Will Zillow Outgrow Its Spending Addiction?

The technology-infused real estate services business is growing fast -- there's no denying that. But with such a rich valuation and skyrocketing costs, it would be in both the company's and investors' best interest to have better transparency.

Web-based real estate services company Zillow(NASDAQ:ZG) is the type of stock a value-oriented investor loves to hate. It's enormously expensive, it posted a net loss in recent earnings while costs doubled, and it's a technology business. Any company, no matter how disruptive the business model, is a tough sell at 135 times expected earnings. Still, Zillow is seeing tremendous growth in its Marketplace -- a service targeting real estate agents and raw user numbers. Zillow is the leader in its space by a long shot, giving it a formidable competitive advantage. Should investors sacrifice their fundamentals and believe in the long-term vision of this real estate disruptor?

Recap"We're in heavy investment mode," said Zillow CEO Spencer Rascoff on CNBC this week. That certainly appears to be the case, according to the company's recently ended quarter.

In the third quarter, Zillow's top-line sales grew 67% to $53.3 million, short of analyst expectations but nonetheless a large leap over the prior year's number. Driving the gain was the aforementioned Marketplace segment, a subscription-based service for real estate agents that gained 76.6% in sales for the quarter. The other player in the company's sales gain were display ads due to an ever-increasing number of visitors to the site.

Within the Marketplace, mortgages that showed the greatest strength -- up nearly 120% from the year-ago quarter based on robust growth in loan requests (totaling 6 million).

Average monthly unique users jumped up nearly 70% year over year, while mobile traffic doubled.

As mentioned, expenses doubled for the year -- totaling $58.8 million. Sales and marketing costs were up more than 100%, while cost of revenue went up more than 40%. Costs kept the bottom line in the red -- a loss of $5.45 million compared to a $2.3 million profit last year.

It's a classic tech-growth scenario: Pay up for the impressive sales and earnings gains or pump the brakes on the runaway costs?

Realtor checkWhat investors don't want is for the company to be pouring cash into sales and marketing to buy the sales gains it achieves -- that is a very risky, unsustainable method of growth. As the company grows so fast, it may be acceptable that sales and marketing expenses are doubling, but there needs to be clarity as to the churn rate in its members. Signing up a member for an introductory month is a relatively easy task. Keeping them for months and years on end is a much different game.

For the long-term viability of Zillow, we need to see if the Marketplace gains are not just new signups but recurring memberships. Management's guidance shows continued growth in all segments, and at a great pace, but there is no mention of user churn rates.

If you're going to pay $150 for every $1 of today's earnings, there needs to be concrete evidence that the business can hold onto its customers.

Author

Michael is a value-oriented investment analyst with a specific interest in retail and media businesses. Before coming to the Fool, Michael worked with private investment funds focusing on deep value and special situations. Currently living in the media capital of the world--Los Angeles, California.